revenue bond

What It Is

Revenue bonds are municipal bonds that are issued to fund specific projects that generate their own revenue.

How It Works

Let's assume ABC Town wants to build a new toll road, but it doesn't have the money to fund the construction. It could issue revenue bonds, and the tolls collected from the toll road would fund the interest and principal payments. If the revenue from the toll road is insufficient, ABC Town might not be able to make timely interest and principal payments. In many cases, revenue bond issuers can avoid or delay interest payments if a minimum amount of revenue is not generated from the project.

Revenue-bond holders generally have no claim to the project’s assets (i.e., they cannot repossess the toll road if it does not generate the promised interest and principal payments). Revenue bonds may also have catastrophe call provisions, which allow the issuer to call the bonds if the revenue-producing facility is destroyed. Thus, revenue bonds generally warrant a higher yield than general obligation bonds to compensate for these added risks.

Revenue bonds usually have $1,000 or $5,000 face values. They usually pay interest semiannually, although some are zero-coupon bonds. Typical maturities are one to 30 years. Many are serial bonds, and many are callable or putable, and some have unusual payment schedules. The issuer sets forth the terms of the debt in the indenture agreement.

Revenue bonds are typically issued the same way corporate bonds are: through an underwriter that presents a written prospectus to buyers and facilitates a competitive bidding process. After the bonds begin trading, municipal bond dealers across the country earn spreads by acting as intermediaries between buyers and sellers. Although purchasing specific revenue bonds and other municipal bonds gives investors direct control over which bonds they hold and the location of the issuers (thus maximizing tax advantages), mutual funds and municipal bond investment trusts are the most common way to invest in revenue bonds and other municipal bonds.

Municipal bonds, in general, rank between agency bonds and corporate bonds in risk and return. As with all debt, they are subject to credit, interest-rate, call, and market risk. To mitigate default risk, some issuers carry private insurance on their bonds (investors can also purchase this insurance). In some cases, a federal agency might guarantee or insure a revenue bond issue. Some issuers also back their bonds with a commercial bank letter of credit or escrow funds.

Why It Matters

One of the largest advantages of investing in revenue bonds is that the interest is usually exempt from federal taxes and most state and local taxes if the investor lives in the state or municipality issuing the debt (capital gains on municipal bonds are taxable, however). Although investors subject to the alternative minimum tax may be subject to taxes, for the most part the exemption means that investors in high federal-tax brackets benefit from revenue bonds and other municipal bonds. This is why there is usually stronger demand for revenue bonds and other municipal bonds in high-tax states (although this demand in turn lowers the yields of these bonds relative to those issued in low-tax states).

As with all bonds, revenue bond prices rise when interest rates fall, and fall when interest rates rise. Inflation can cut significantly into a revenue bond's modest returns (relative to corporate bonds), although variable-rate revenue bonds do offer some protection against this.

Pending or suspected tax legislation can dramatically affect the value of revenue bonds. Remember, the higher the marginal tax rate, the more valuable a revenue bond's tax exemption is. If a state or the federal government reduces tax rates, revenue bonds lose some of their advantage for high-tax-bracket individuals (and thus become less valuable). Another risk is that the IRS may decide to tax municipal bond income or revoke the exemption of a particular issue.

Source: Investing Answers